Definition:
Decision analysis is a systematic and quantifiable approach to addressing and evaluating important choices facing a business or organization.
- What it is: Decision analysis is the process by which you identify alternative options for a business/organizational decision, and then financially model the potential outcome of each alternative. Implemented correctly, the financial decision analysis model will identify the value maximizing recommendation. Every business or organizational decision has a financial element. If you carefully consider all of the elements that are affected by each alternative option, you can assign financial impact to every outcome. Even ethical, moral and social issues have an impact and in a well-run business, you take into account the financial consequences of bad legal, ethical or social decisions. Therefore you can financially model each alternative option to identify the value maximizing recommendation.
- What does it do: If you carefully consider all of the potential impacts on the business or organization of the alternative options, you can measure the financial impact by assigning financial consequences to each outcome. If you have carefully considered all impacts, the alternative option with the optimum financial impact will also be the best decision for the business.
Uses:
- How is it used: When a business or organization is faced with an important decision it is critical that they consider the financial impact of the various options they are considering. Even in the process of defining options, it is important to consider the financial impacts as you narrow the list of alternative options to be considered. Once you have considered the impacts and outcomes of each alternative being considered, you assign financial measurements to the outcomes. Then you can use a financial model to compare the alternatives to find the value-maximizing option.
- Where: Decision analysis should be used anytime the impact associated with the outcomes of different alternative options is greater than the cost of the analysis. Some examples of where you could use financial decision analysis:
- Decisions to Build, Buy or Borrow: Whether you are planning for a manufacturing facility or a training course to be used in HR, there are always alternatives. Most commonly the alternatives are related to Build, Buy or Borrow. The build is where you build the plant or training program yourself through your own research and in-house expertise. Buy is where you buy off the shelf manufacturing capabilities or standard training programs. Borrow is where you create some form of alliance, lease, rent, contract, JV, or other mechanisms where you pay for temporary use or borrow someone else's resources to meet your needs.
- Repair or Replace: The decision analysis compares the costs and rewards of repairing an item or replacing it. The model will consider the remaining useful life of the item if repaired and the future cost of replacement compared to the immediate costs of replacement. Things to consider in the analysis considers the time value of money, the cost of raising capital, the productivity and efficiency of the repaired item versus a replacement item with potentially superior technology, performance, and efficiency. Be careful to consider collateral costs of the changes including installation, downtime, qualification of products with customers, etc.
- Should we Implement the Decision or Program: When you have an HR, Marketing, Supply Chain, IT or other program being proposed you need to decide if the program will create or destroy value. This is often done by considering all of the expenses and capital associated with implementing the program and comparing that to the increased revenues, increased productivity or reduced costs. The analysis normally includes things like income statements and balance sheets, Net Present Value (NPV), Internal Rate of Return (IRR) or other financial measurements.
- Decide between Program Options: In managing a portfolio of businesses, departments, or products there will be times when there are limited capital and budget to approve all of the projects that indicate they will create value. There may be 5 different products that all create positive NPV and IRRs above the company's approved returns, but only capital and budget to fund 3 of the projects. How do you determine which of the 5 projects will be approved? You can complete financial models for each combination of projects in case there are some synergistic relationships between some of the programs. This way the outcome of the income statements and balance sheets can indicate which combination of projects will create the most net profit or EBITDA (earnings before interest, taxes, depreciation, and amortization which is a proxy for cash flow). If you are choosing between projects you could compare NPV or IRR or other appropriate measurements (be sure to consider limitations to the financial measures). The same is true for other investments and acquisitions.
- Why: Decisions that are made on opinion and gut feel have the potential of missing the impact of important factors. Those types of decisions have the potential of destroying value and sub-optimizing the resources of the company/organization.
Limitations:
- Where it shouldn't be used: There are people who say that you cannot use financial decision analysis where legal, social, and ethical issues are concerned, but many believe that when you indicate the negative impact of those types of decisions on the company, then the financial analysis will still indicate a legal/ethical outcome as most profitable. But in case there is a situation where it makes better financial outcomes to pay the legal fines or take the chance on negative publicity; then the company should fall back on its values to avoid the negative non-financial impacts of illegal or unethical behavior.
- Any restrictions: When there is large uncertainty about future outcomes, it is important to create a probabilistic analysis. Probabilistic Analysis considers the range of financial impact based on the likely variability of the assumptions about future outcomes. When you compare the ranges or rewards and risks, the financial decision is made easier.
- Warnings: If there is the potential that the outcomes (e.g. profits created from alternative marketing approaches) of three alternative recommendations could be as much as $1,000 and the analysis could be completed in 2 hours, then you should complete a financial decision analysis. But if the difference in the possible outcomes of three recommendations is $10,000 but will take 2 months and 1,000 hours of effort, then you should not complete the analysis. But you could look for ways to simplify the analysis with some simplifying assumptions. If the uncertainty created by the simplifying assumptions (and the cost of analysis) is less than the differences between the financial outcomes of the alternative options, then the simplified analysis can be acceptable to approve the suggested recommendation.
Demonstrations:
Step-by-step process:
- Gathering data
- Specify the options you are considering to make as part of your business decision
- Identify parameters that could be affected by each of the options being considered
- Determine the type of model needed (i.e. Income statement, options table, action table, etc., for the rest of the steps we will assume income statement)
- Define the level of detail necessary to capture the differences in the income statement line items used to evaluate the decision
- Create the status quo income statement and add columns for each option
- Work with Marketing, Manufacturing, Supply chain and any other function which might be impacted to define how the income statement line items would change under each option
- Determine the level of uncertainty in the data to decide whether or not a probabilistic model is required to measure uncertainty and risk
- Analysis of data
- Fill in the data for each option on the income statement to compare to the status quo
- Determine if the model needs to be probabilistic to account for variations beyond the control of the company (if so see financial modeling or probabilistic modeling)
- If multiple years are needed to value options then create income statements for each of the relevant years and then create an NPV for each option
- Create all of the relevant analytical tools in the spreadsheet such as Gross Margin, Net Income, NOPAT, Cashflow, Payback, ROI, ROE, NPV, etc.
- Interpretation of results
- Based on the company risk profile and desired outcomes determine the option that best meets their objectives
- Consider the risks and rewards associated with each option as well as the level of uncertainty.
- If the level of uncertainty is greater than the differences between the options (and large enough to be considered relevant) than further probabilistic analysis may be required
- Consider "Bang for the Buck" in your recommendation (how much do you have to invest or put at risk to receive the reward). The bigger the bang (% return on the investment) the better.
- Decide if the financial differences between the options are adequate to make a financial recommendation needed
- Make your recommendation based on your analysis of the risk and profile of the decision and the company culture and practices
- Presentation of Results
- The use of graphs (Bar Charts, Line charts or efficient frontiers) are often used to display the recommendations
- Decision tables are also a useful approach
- There is value in highlighting the sources of the differences by line item for each relevant option to illuminate the source of the value creation of the recommendation.
Template for capturing data:
There are many different models that can be used in decision analysis. In many cases, a simple income statement can show the impact of decision options. I have included a simple Income model link below:
Decision Analysis IS.xlsx
Output representation and recommendations:
Options are often shown in Bar charts, Options tables or other displays to highlight different financial outcomes.
Examples: Social Media Resource Allocation Example
In the link below there is an analysis of applying resources to a marketing plan for social media.
- The marketing department has recommended that resources be divided equally (20% each) over for social media platforms.
- The financial department completed a financial decision analysis and made a different recommendation in the spreadsheet linked below.
- See the sources of analysis and the financial outcome and recommendations at the bottom of the spreadsheet. Compare the recommended outcome versus the original proposal.
- Decision Analysis Social Media Example: Decision Analysis Social Media Example.xlsx
Additional resources:
